A Beginners Guide to Different Types of Financial Products

Hi everyone, please welcome Troy Bombardia to Cents, Sense & Sensibility today. He is an investor and staff writer over at Make Money Your Way and is here to share his knowledge with us on investing for beginners. This is the second installment of the Investing Crash Course. Please go to Investing Crash Course: Week 1 for the first post.

Take it away Troy:

Before I discuss the ins and outs of various types of financial products, let me be forthcoming. I have traded and invested in some of the financial products (although exactly which ones I will not say), so I do have experience with them. However, there are certain financial products that I will not touch with a 6 foot pole. This is either because:

– The product is dangerous (and I’ll explain why), or

– I just don’t have enough knowledge about the complicated financial product.

So first of all, what is a financial product? A financial product, or what is sometimes called an investment vehicle / instrument, is something that you can invest your money in or trade. (And for people who invest and buy blogs out there, those are not financial products.) For example, stocks are just one type of financial products. There are various different types of financial products, and I will explain what each of the major types are.

Individual Stocks

This is the one that you’re all probably familiar with. You can define a stock in 2 ways:

A stock, by Warren Buffett’s definition, is part ownership in a company.

A stock, by most definitions, is simply something you invest in and hope to earn capital gains on.

Back in the 1950s, Warren Buffett was really fond of saying that a stock wasn’t only a piece of paper – it represented part ownership in a company. If you bought enough shares, you can practically own the company! This meant that once you owned the company, you made $ not from capital gains (appreciation in the stock’s value) but from the corporate profits.

While this is true for rich guys like Warren Buffett who have the billions of dollars required to buy all that stock, you and I cannot view a stock this way. We don’t have enough money to buy the whole company. So remember, when buying a stock you’re going to profit from the stock price going up. The stock price going up doesn’t have a strong correlation with the profits a company earns from its revenues.

Personally, I don’t really like investing or trading individual stocks, although I have traded certain stock sectors on the rare occasion (ie gold miners). This is because when you invest or trade individual stocks, you have to worry about two things:

How to overall stock market will perform.

How the company that you bought shares in will perform.

Sometimes, these 2 things conflict. What happens if the company that you bought shares in is making big profits but the overall stock market is tanking? Will your stock rise or fall? It’s hard to say which of these 2 factors will have a bigger impact on your stock’s price.

Investing is hard enough – let’s not make it any more difficult. Investing will be easier if you focus on only 1 of the 2 factors: how the overall stock market will perform. The only way to invest in the overall stock market is by using a financial product known as ETF’s…

ETF’s

Technically speaking, an ETF (shorthand for Exchange Traded Fund) is also a stock. ETF’s are traded on various stock exchanges around the world. However, an ETF is not a share in a company (ie Apple stock). An ETF is simply a financial instrument created by big funds / banks for the sole purpose of mimicking an underlying market.

ETF’s exist for all kinds of markets. For example, there is Dow Jones 30 ETF and there is also an S&P500 ETF. By investing in these ETF’s, you’re essentially “buying” the whole stock market, which is a lot easier to picking individual stocks. These ETF’s mimick the real gains and losses of the Dow or S&P500.

In addition, ETF’s exist beyond stocks. For example, there are gold and silver ETF’s, which I actively trade. The beauty about gold and silver ETF’s is that prior to the 1990s, people like you and me could not really invest in precious metals. Back then, you only had 2 choices:

Trade gold / silver futures. Each “futures contract” (think of it as 1 share, the minimum you need to invest) is something atune to the hundreds of thousands of dollars.

Buy physical gold from dealers. The problem with this is that the dealers will slap a 20% premium on the gold they sell, which means that from day 1 you’ve just lost 20%.

This is where ETF’s come in. ETF’s track the price of gold and silver. So by buying or selling a gold / silver ETF, you’re making the same profits / losses as if you were to actually buy gold / silver at the spot price. Neat huh? In addition, there are oil, copper, and sugar ETF’s that do the same thing – track the profits and losses of their underlying markets.

Nowadays, there are also ETF’s for individual stock sectors. For example, there is a gold miner ETF that seeks to track the performance of the gold mining industry. There is a finance ETF that seeks to track the performance of the major Wall Street banks.

Derivatives

The third major type of financial products are known as derivatives. These are highly complicated financial instruments that I don’t even touch. In fact, these are so complicated that a couple of years ago there was a Senate hearing debating the merits of derivatives. Warren Buffett was called in to shed light on this matter because some academics though that derivatives caused the 2008 financial crisis or not.

The definition of derivatives is easy to memorize: derivatives “derive” their prices from something else. These financial products are so complex that a short explanation will confuse you more than shed light on this topic. Just keep in mind that derivatives are not for investors – these are created solely for trading. All you need to know is that unless you’re highly knowledgeable about these products and have a ton of trading experience, derivatives will result in huge losses in a heartbeat.

There are many different types of derivatives, the 2 main ones being options and futures:

The essential difference between an option and a future is that options are even more volatile than futures. I’ve heard stories of people losing 60% of their money within 2 hours in options. Scary stuff.

I appreciate you taking time out of your day to read this. For y’all bloggers out there, I’ve created a non-profit blog about the Ghost blogging platform (something akin to WordPress and Blogger). So if you’re interested, please feel free to read my tutorial on how to install Ghost (it’s free!). I do web-related stuff in my spare time when I’m not trading. And one last thing – I’d just like to add a caveat. The U.S. stock market at the moment is pretty overheated. If you look at investor sentiment, everyone has been insanely bullish since the middle of 2012. This is usually not a very good sign.